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When will the Bank of Canada raise interest rates and by how much?

General Angela Calla 13 Apr

Posted to FP: April 12, 2010, Jonathan Ratner

With most agreeing that a rate hike from the Bank of Canada is imminent, the talk now turns to the exact timing and extent of the central bank’s policy changes.

Governor Mark Carney made a “conditional” promise to keep the benchmark interest rate at 0.25% through the end of June 2010. However, one way to keep to this expiry date and provide markets with a jolt would be an initial rate hike of 50 basis points on July 20, according to Bank of America Merrill Lynch economist Sheryl King.

“Futures markets are only partially pricing in that possibility so it would be a shot across the bow to be sure,” she said in a note. “The strongest argument against this tack in our view is that the market would immediately rush to the conclusion that all future hikes will be similar in size.”

The economist thinks a 25 basis point hike on June 1 is the most likely scenario.

Meanwhile, Ms. King feels a 25 basis point hike on July 20 is the least likely scenario. She noted that this expectation is already fully priced into the Eurodollar and overnight index swap (OIS) markets. “If the Bank wants to elevate the risk premium in the bond market, validating market pricing cannot be the way they will go.”

The economist said that with growth running 40% faster than the Bank of Canada’s January forecasts, a rollover in unemployment and core CPI “frustratingly high,” there is justification to move a bit early. She added that moving early rather than large would help build up that needed risk premium without having 10-year notes move above the 6% mark that a normalized risk premium of 1.8% and a neutral overnight rate of roughly 4.5% would command.

The main arguement against a June 1 rate hike is that it comes ahead of the June 30 expiry commitment and puts the Bank’s credibility in the market at risk. Ms. King insists that credibility in achieving the central bank’s 2% inflation target is “very arguably the more important badge to maintain.”

“All along, the Bank has warned investors the commitment to not touch rates was not a promise and earlier rate hikes possible if conditions warranted.”